Interest Credits (con’d)
From the contract owner’s point of view, the accumulation of funds in a fixed annuity is certain and the contract owner's principal is secure. The annuity company bears the investment risk. Variable annuities shift the investment risk from the insurer to the contract owner. If the investments supporting the contract perform well (as in a "bull market"), the owner will probably realize investment growth that exceeds what is possible in a fixed annuity. However, the lack of an investment guarantee means that the variable annuity owner can see the value of his or her annuity decrease in a depressed market or in an economic recession.
The distinguishing feature of a variable annuity is the “separate account”, also called the "subaccount". The contractholder’s premium contributions are credited to a separate investment account – not the annuity company’s general account. Historically, separate accounts invested in securities designed to protect against inflation, primarily common stocks. Today, most annuity companies offer a variety of investment options ranging from money market funds to real estate-backed securities. (Most contracts also offer the variable contractholder a "fixed" investment alternative, which mimics the guaranteed interest rate of a fixed annuity.) Contractholders may choose to diversify their investments by directing their premiums into a variety of separate accounts and many companies offer services to periodically reallocate investments within the separate accounts to maintain desired investment balance. The contract owner may also decide to change investments from one separate account to another at little or no cost as market conditions change.
During the accumulation period, the value of the contract will vary according to the investment results in the separate account(s). When the contract is annuitized, and annuity payments begin, the size of those payments will also be based on the investment results of the separate account. This exposes the annuitant to investment risk. Variable annuity payments are subject to changing market conditions – but that was the intent of variable annuities in the first place. Annuity companies measure changing investment values using accumulation units, which pertains to the accumulation period, and annuity units, which pertains to the income payout period.
During the accumulation period of a variable annuity, contributions made by the investor are converted into accumulation units and credited to the selected separate account. Any additional contributions will purchase more accumulation units. The value of each accumulation unit varies, depending on the value of the underlying portfolio. In this way, accumulation units are similar, but not identical, to shares of a mutual fund.
The current value of one accumulation unit is found each business day by dividing the total value of the company's separate account by the total number of accumulation units outstanding. As the value of the investment portfolio rises and falls, the value of each accumulation unit also rises and falls.
When the investor decides it is time to “annuitize ” the variable contract — and begins to receive monthly income payments — the accumulation units in the participant's individual account are converted into annuity units. From then on, the number of annuity units remains the same for that annuitant. The value of one annuity unit, however, can and does vary from month to month, depending on investment results.
When computing the number of annuity units, the annuity company considers the accumulated value of the account (total number of accumulation units multiplied by the current value of one accumulation unit). The company then takes into account the annuitant’s age and the method of payout the annuitant selects. Using tables similar to those for a fixed annuity, the company determines the size of the initial monthly payment. Then it converts that amount into annuity units by dividing the initial monthly payment by the current value of one annuity unit.
A contractholder has purchased 10,000 accumulation units in her account by the time she is ready to retire at age 55 when the value of one accumulation unit is $25, so the value of the account is $250,000. She selects a joint-full survivor annuity covering her and her 65-year old husband. Based on their ages, the annuity company determines that she is entitled to $4.08 in monthly payments for every $1,000 of accumulated value. Her initial monthly check will be for $1,020.00 ($4.08 x 250 “thousands”). The annuity company will convert that value into annuity units. Assume that an annuity unit at that time is worth $10. The $1,020 payment is converted into 102 annuity units ($1,020 divided by $10). That number is fixed for the rest of their lives – it will not change. What does change is the value of the annuity units, depending on the investments in the underlying separate account. For example, if the annuity unit were to grow to $11, her monthly check would grow too – to $1,122 (102 units at $11).
Each variable annuity contract will have an assumed interest rate (AIR). The varying value of annuity units depends on how the investment results in the separate account compare with that assumed interest rate. If the growth in the account equals the AIR, the value of an annuity unit will not change. If the investments in the separate account do better than the AIR, the value of the annuity unit will grow. If investment results lag the AIR, the value of the annuity unit will fall. In the illustration below, the AIR is 4%. In the years when the investment results are higher than 4%, the value of the annuity unit increases. When the investment result is matches the 4% AIR, the annuity unit’s value remains unchanged. In the years when the results were only 3%, the annuity unit decreased in value each year.
Please note: the assumed interest rate in a variable contract is a threshold against which to compare investment results in the separate account – it is not a guaranteed rate of return.
Each variable annuity contract will outline the formula used to determine annuity unit values. Some contracts may rely solely on investment experience only (how the portfolio performed versus the AIR), while formulas in other contracts may reflect mortality and expense experience too.